12/14/2011

Mitt Romney’s career at Bain Capital buying up and restructuring companies — sometimes with major job cuts along the way — has been a glaring vulnerability since his earliest political runs. But it’s rarely come up in his two presidential campaigns, where the GOP’s investor-friendly ethos has made rivals hesitant to use it against him. Until now, that is.

Newt Gingrich got the toughest shot in on Monday, suggesting that Romney’s time at Bain showed he was heartless and out of touch with the average American.

“I would just say that if Gov. Romney would like to give back all of the money he’s earned from bankrupting companies and laying off employees over his years at Bain, that I would be glad to listen to him,” Gingrich told reporters.

Newt Gingrich ... provided on Monday redundant evidence for the proposition that he is the least conservative candidate seeking the Republican presidential nomination: He faulted Mitt Romney for committing acts of capitalism.

According to Fox News, Charles Krauthammer opined that "Newt’s Attack on Romney [is] ‘What You’d Expect from a Socialist"

Jonathan Adler once again demonstrated his considerable acumen by observing that:

Gingrich has a disturbing habit of making off-the-cuff comments that reveal a lack of appreciation (if not outright hostility) for free enterprise. ... Gingrich is either an opportunist, or (more likely) more of a technocratic futurist (recall his fascination with the Tofflers) than a genuine believer in free enterprise.

I'm no Romney fan, but on this issue I think Will, Krauthammer, and Adler are right that Gingrich is off his meds (as is so often the case).

Gingrich is basically parroting the AFL-CIO/Occupy Wall Street/left-liberal populist account of private equity funds and corporate takeovers. The claim is the private equity comes along, buys the company, loots it, and leaves behind an empty shell and shattered lives. The attack of a Kos diarist is typical of the breed:

Bain Capital's behavior towards the Illinois medical supply company Dade International is a perfect microcosm of what Americans feel has been done to their country over the past twenty years. While Romney's firm netted 242 million dollars, eight times its original investment, the company ended up laying off 1700 workers and filing for bankruptcy. The only word that adequately captures what Romney and Bain did here would be "looting" ....

A system that allows companies that aren't good and let themselves be overtaken by technological change creates more jobs and prosperity over the long term. The economist Joseph Schumpeter called it creative destruction: it's only by letting outdated companies fail that we can free up the resources that allow new companies to become huge and introduce new goods and services that make us all better off.

Or, instead of letting them fail, letting them be acquired in a corporate takeover and thereafter restructured, which is what Bain Capital did.

In the leading study of the impact of private equity firms like Bain Capital on employment, a group of economists working with US Census data tracked "employment before and after private equity transactions at the level of firms and establishments – i.e., specific factories, offices, retail outlets and other distinct physical locations where business takes place." It's true that they found that "employment shrinks more rapidly, on average, at target establishments than at controls after private equity transactions," but that is due to "higher rates of job destruction at shrinking and exiting establishments. In fact, the post-transaction creation of new jobs at expanding establishments is greater for targets than controls." (4)

In addition, the economists point out that focusing on losses at closing or shrinking firm establishments "misses job creation at newly opened establishments ...." (4) It turns out that targets of private equity takeovers "engage in more greenfield job creation than control firms ..." (4)

Summing over job creation and destruction at continuing establishments, job losses at establishments that shut down, job gains at greenfield establishments, and the contributions of acquisitions and divestitures, employment shrinks by less than 1% at target firms relative to controls in the first two years after private equity buyouts. ...

These results indicate that private equity buyouts catalyze the creative destruction process, at least as measured by job creation and destruction and by the transfer of production units between firms. (5)

One especially critical finding is summarized as follows:

... we provide evidence that employment responses to private equity buyouts vary considerably across industries and by type of transaction. The largest employment losses at targets relative to controls occur in Retail Trade. Public-to-private deals, which tend to be highly visible, also involve large employment losses at targets relative to controls. In contrast, independently owned firms exhibit large employment gains relative to controls in the wake of buyouts, mainly due to greater acquisitions. Private equity buyouts of independent firms are more numerous than public-to-private transactions, and they account for a larger share of jobs. (33)

This finding confirms that the left/Gingrich critique of private equity is skewed by what behavioral economists refer to as the availability heuristic:

Essentially the availability heuristic operates on the notion that "if you can think of it, it must be important."[1] Media coverage can help fuel a person's example bias with widespread and extensive coverage of unusual events, such as homicide or airline accidents, and less coverage of more routine, less sensational events, such as common diseases or car accidents. For example, when asked to rate the probability of a variety of causes of death, people tend to rate more "newsworthy" events as more likely because they can more readily recall an example from memory.

Job losses are concentrated in takeovers that are visible to the media and therefore to the public. The public doesn't see the vastly larger number of acquisitions of privately held companies, which "exhibit large employment gains."

In sum, employment losses as a result of private equity transactions are modest and a consequence of the creative destruction process by which capitalism periodically shakes up firms that have become inefficient dinosaurs.

I don't find these results particularly surprising. To the contrary, they are consistent with the analysis of the economic impact of corporate takeovers offered in my book Mergers and Acqquisitions, in which I explained that:

There are any number of problems with this thesis, however. For one thing, there is no credible evidence that takeovers transfer wealth from nonshareholder constituencies to shareholders.

Instead, much of the social wealth created by corporate takeovers comes from displacing inefficient managers:

The agency cost literature describes two basic types of managerial inefficiency. The first is misfeasance: If managers worked harder, were smarter, or were more careful they would earn more money for shareholders. The second is malfeasance: Managers cheat the corporation or lavish perks on themselves. The annals of American business corporations are replete with examples of both forms of shirking, ranging from congenital unluckiness, to incompetence, to outright theft.

Experience teaches that most successful business people are smart, hard working, and honest, however. Is it nevertheless possible that smart, hard working, reasonably honest people might be "inefficient" and therefore in need of replacing? An affirmative answer is suggested by the so called "free cash flow" theory: Successful managers end up with a lot of cash for which they have no good use. In technical terms, they end up with cash flows greater than the positive net present value investments available to the firm. Disbursing these free cash flows to shareholders in the form of dividends would (a) be costly because of the double taxation on dividends and (b) increase management risks because a smaller asset pool increases the risk of firm failure in the event of financial reverses. Accordingly, even well meaning managers have an incentive to retain free cash flow by making negative net present value investments. A takeover releases most of those funds, while earning the acquirer a profit from the remainder.

No matter the source or form of director or management shirking, it should be reflected in a declining market price for the stock of the company. Bad management is just another form of information that efficient markets are able to process. When a declining market price signals shirking by directors or management, among those who receive the signal are directors and managers of other firms, who possess the resources to investigate the reason for the potential target's deteriorating performance. Sometimes it will be something that is beyond anybody's ability to control, such as where highly specialized assets are languishing because of a permanent shift in consumer demand. Sometimes, however, it will be due to poor management, which presents real opportunities for gain if the personnel or policies causing the firm to languish can be corrected. A successful takeover gives the acquirer the ability to elect at least a majority of the board of directors and thereby control personnel and policy decisions. The resulting appreciation in value of the acquired shares provides the profit incentive to do so. It is partly for this reason that we refer to the takeover market as "the market for corporate control."

The potential to create value through this market has important ... policy implications. Keeping the stock price up is one of the best defenses managers have against being displaced in a takeover. Accordingly, the market for corporate control is an important mechanism for preventing management shirking and thus for minimizing the agency costs associated with conducting business in the corporate form.

Granted, this is not the only way in which takeovers create social wealth. It may not even be the most important way. But is one of the ways in which the creative destruction worked by takeovers makes the economy more efficient and frees up new social wealth.

My text further identifies other ways in which corporate takeovers promote social welfare through creative destruction:

Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate's exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra firm diversification reduces shareholder wealth. The self correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so called "bust up" takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts.

Private equity firms played a huge role in busting up the conglomerate dinosaurs. Without a working corporate takeover model, however, the dinosaurs would still be clogging up our economy with their inefficient and outdated model.

Another good example is the way corporate takeovers act as a check on empire-building:

Bigger is typically better from management's perspective. Just like putting oriental rugs down on the floor, bigger organizational charts on the wall are a management perk. If size reduces the chances of firm failure, management even has a financial incentive to pursue such acquisitions. As with acquisitions motivated by a desire for intra firm diversification, empire building acquisitions doubtless reduce shareholder wealth. Free markets are self correcting, however. Empirical studies confirm that bidders motivated by considerations other than shareholder wealth maximization themselves tend to become targets.

I am not a fan of unregulated markets for corporate control. But I'm utterly unconvinced by the liberal populist critiqque, which is uttlerly lacking in facts, let alone the sort of nuance that a legitimate analysis must reflect.

And Gingrich is way off the mark by lining up the far left's misguided economic theories.

Comments

Mitt Romney’s career at Bain Capital buying up and restructuring companies — sometimes with major job cuts along the way — has been a glaring vulnerability since his earliest political runs. But it’s rarely come up in his two presidential campaigns, where the GOP’s investor-friendly ethos has made rivals hesitant to use it against him. Until now, that is.

Newt Gingrich got the toughest shot in on Monday, suggesting that Romney’s time at Bain showed he was heartless and out of touch with the average American.

“I would just say that if Gov. Romney would like to give back all of the money he’s earned from bankrupting companies and laying off employees over his years at Bain, that I would be glad to listen to him,” Gingrich told reporters.

Newt Gingrich ... provided on Monday redundant evidence for the proposition that he is the least conservative candidate seeking the Republican presidential nomination: He faulted Mitt Romney for committing acts of capitalism.

According to Fox News, Charles Krauthammer opined that "Newt’s Attack on Romney [is] ‘What You’d Expect from a Socialist"

Jonathan Adler once again demonstrated his considerable acumen by observing that:

Gingrich has a disturbing habit of making off-the-cuff comments that reveal a lack of appreciation (if not outright hostility) for free enterprise. ... Gingrich is either an opportunist, or (more likely) more of a technocratic futurist (recall his fascination with the Tofflers) than a genuine believer in free enterprise.

I'm no Romney fan, but on this issue I think Will, Krauthammer, and Adler are right that Gingrich is off his meds (as is so often the case).

Gingrich is basically parroting the AFL-CIO/Occupy Wall Street/left-liberal populist account of private equity funds and corporate takeovers. The claim is the private equity comes along, buys the company, loots it, and leaves behind an empty shell and shattered lives. The attack of a Kos diarist is typical of the breed:

Bain Capital's behavior towards the Illinois medical supply company Dade International is a perfect microcosm of what Americans feel has been done to their country over the past twenty years. While Romney's firm netted 242 million dollars, eight times its original investment, the company ended up laying off 1700 workers and filing for bankruptcy. The only word that adequately captures what Romney and Bain did here would be "looting" ....

A system that allows companies that aren't good and let themselves be overtaken by technological change creates more jobs and prosperity over the long term. The economist Joseph Schumpeter called it creative destruction: it's only by letting outdated companies fail that we can free up the resources that allow new companies to become huge and introduce new goods and services that make us all better off.

Or, instead of letting them fail, letting them be acquired in a corporate takeover and thereafter restructured, which is what Bain Capital did.

In the leading study of the impact of private equity firms like Bain Capital on employment, a group of economists working with US Census data tracked "employment before and after private equity transactions at the level of firms and establishments – i.e., specific factories, offices, retail outlets and other distinct physical locations where business takes place." It's true that they found that "employment shrinks more rapidly, on average, at target establishments than at controls after private equity transactions," but that is due to "higher rates of job destruction at shrinking and exiting establishments. In fact, the post-transaction creation of new jobs at expanding establishments is greater for targets than controls." (4)

In addition, the economists point out that focusing on losses at closing or shrinking firm establishments "misses job creation at newly opened establishments ...." (4) It turns out that targets of private equity takeovers "engage in more greenfield job creation than control firms ..." (4)

Summing over job creation and destruction at continuing establishments, job losses at establishments that shut down, job gains at greenfield establishments, and the contributions of acquisitions and divestitures, employment shrinks by less than 1% at target firms relative to controls in the first two years after private equity buyouts. ...

These results indicate that private equity buyouts catalyze the creative destruction process, at least as measured by job creation and destruction and by the transfer of production units between firms. (5)

One especially critical finding is summarized as follows:

... we provide evidence that employment responses to private equity buyouts vary considerably across industries and by type of transaction. The largest employment losses at targets relative to controls occur in Retail Trade. Public-to-private deals, which tend to be highly visible, also involve large employment losses at targets relative to controls. In contrast, independently owned firms exhibit large employment gains relative to controls in the wake of buyouts, mainly due to greater acquisitions. Private equity buyouts of independent firms are more numerous than public-to-private transactions, and they account for a larger share of jobs. (33)

This finding confirms that the left/Gingrich critique of private equity is skewed by what behavioral economists refer to as the availability heuristic:

Essentially the availability heuristic operates on the notion that "if you can think of it, it must be important."[1] Media coverage can help fuel a person's example bias with widespread and extensive coverage of unusual events, such as homicide or airline accidents, and less coverage of more routine, less sensational events, such as common diseases or car accidents. For example, when asked to rate the probability of a variety of causes of death, people tend to rate more "newsworthy" events as more likely because they can more readily recall an example from memory.

Job losses are concentrated in takeovers that are visible to the media and therefore to the public. The public doesn't see the vastly larger number of acquisitions of privately held companies, which "exhibit large employment gains."

In sum, employment losses as a result of private equity transactions are modest and a consequence of the creative destruction process by which capitalism periodically shakes up firms that have become inefficient dinosaurs.

I don't find these results particularly surprising. To the contrary, they are consistent with the analysis of the economic impact of corporate takeovers offered in my book Mergers and Acqquisitions, in which I explained that:

There are any number of problems with this thesis, however. For one thing, there is no credible evidence that takeovers transfer wealth from nonshareholder constituencies to shareholders.

Instead, much of the social wealth created by corporate takeovers comes from displacing inefficient managers:

The agency cost literature describes two basic types of managerial inefficiency. The first is misfeasance: If managers worked harder, were smarter, or were more careful they would earn more money for shareholders. The second is malfeasance: Managers cheat the corporation or lavish perks on themselves. The annals of American business corporations are replete with examples of both forms of shirking, ranging from congenital unluckiness, to incompetence, to outright theft.

Experience teaches that most successful business people are smart, hard working, and honest, however. Is it nevertheless possible that smart, hard working, reasonably honest people might be "inefficient" and therefore in need of replacing? An affirmative answer is suggested by the so called "free cash flow" theory: Successful managers end up with a lot of cash for which they have no good use. In technical terms, they end up with cash flows greater than the positive net present value investments available to the firm. Disbursing these free cash flows to shareholders in the form of dividends would (a) be costly because of the double taxation on dividends and (b) increase management risks because a smaller asset pool increases the risk of firm failure in the event of financial reverses. Accordingly, even well meaning managers have an incentive to retain free cash flow by making negative net present value investments. A takeover releases most of those funds, while earning the acquirer a profit from the remainder.

No matter the source or form of director or management shirking, it should be reflected in a declining market price for the stock of the company. Bad management is just another form of information that efficient markets are able to process. When a declining market price signals shirking by directors or management, among those who receive the signal are directors and managers of other firms, who possess the resources to investigate the reason for the potential target's deteriorating performance. Sometimes it will be something that is beyond anybody's ability to control, such as where highly specialized assets are languishing because of a permanent shift in consumer demand. Sometimes, however, it will be due to poor management, which presents real opportunities for gain if the personnel or policies causing the firm to languish can be corrected. A successful takeover gives the acquirer the ability to elect at least a majority of the board of directors and thereby control personnel and policy decisions. The resulting appreciation in value of the acquired shares provides the profit incentive to do so. It is partly for this reason that we refer to the takeover market as "the market for corporate control."

The potential to create value through this market has important ... policy implications. Keeping the stock price up is one of the best defenses managers have against being displaced in a takeover. Accordingly, the market for corporate control is an important mechanism for preventing management shirking and thus for minimizing the agency costs associated with conducting business in the corporate form.

Granted, this is not the only way in which takeovers create social wealth. It may not even be the most important way. But is one of the ways in which the creative destruction worked by takeovers makes the economy more efficient and frees up new social wealth.

My text further identifies other ways in which corporate takeovers promote social welfare through creative destruction:

Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate's exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra firm diversification reduces shareholder wealth. The self correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so called "bust up" takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts.

Private equity firms played a huge role in busting up the conglomerate dinosaurs. Without a working corporate takeover model, however, the dinosaurs would still be clogging up our economy with their inefficient and outdated model.

Another good example is the way corporate takeovers act as a check on empire-building:

Bigger is typically better from management's perspective. Just like putting oriental rugs down on the floor, bigger organizational charts on the wall are a management perk. If size reduces the chances of firm failure, management even has a financial incentive to pursue such acquisitions. As with acquisitions motivated by a desire for intra firm diversification, empire building acquisitions doubtless reduce shareholder wealth. Free markets are self correcting, however. Empirical studies confirm that bidders motivated by considerations other than shareholder wealth maximization themselves tend to become targets.

I am not a fan of unregulated markets for corporate control. But I'm utterly unconvinced by the liberal populist critiqque, which is uttlerly lacking in facts, let alone the sort of nuance that a legitimate analysis must reflect.

And Gingrich is way off the mark by lining up the far left's misguided economic theories.